How to Survive a Bear Market: Don’t Short Failing Companies, Frauds or Fads, and If You Do: Use Options

The key is not to kill the bear, but to survive long enough to re-group.

I wrote these rules back during the GME rise but they still ring true. The reason why option regulators are getting concerned is the evolution of options trading has become so rapid and the uncertainty so high, existing measures to evaluate and measure risk no longer apply.

So what does this mean? Optionality and the ability to limit yourself to a finite loss is becoming more and more valuable as the possible distribution of outcomes is constantly challenged by irrational consumers and artificial intelligence.

“Portfolio insurance” was the term used by automated selling systems that helped facilitate the (flashes of different length) crashes including May 6th 2010. It turns out if everyone is doing the same thing it creates a problem that is fueled by changes to existing laws (see the regulation leading up to the National Best Bid Offer legislation).

The simple answer I have is buy puts. Yes you have the implied volatility crush to worry about but the returns on puts purchased with a predetermined amount of capital can offer you a chance to participate in the gains resulting from market carnage. The best part, your not exposed to the risks of short selling and can only have a loss equal to the premium you paid.

In my opinion having the ability to cut your losses this easily is overlooked and the unpredictability of price action is not yet reflected in the Black Scholes models and other variations employed by many underwriters. Changes in regulatory requirements for margin further articulate this risk to the sellers of options. Saving enough chips to play another day is paramount if you want to continue to invest over the long term, but it requires a deeper toolbox and the right tools for the right job. In the case of people looking to short the current frothy market, consider these three cases and at least the use of options to manage risk.

For everyone who thinks all short-selling is bad, consider how strong the conviction must be for a fund to take an unhedged short position after GME and other squeezing bankrupted “Smart Money.” Strategies that involved using leverage to take on risk far greater than could be justified by any gains resulted in losses far above the threshold any reasonable asset manager should allow. There is a reason why taking short positions, has more than purely negative implications for the markets. Before you get mad, let me explain how it can actually can contribute to healthy markets. More importantly, I will talk about how limiting buy orders is far more destructive to shareholders.

A company can take short positions in a number of ways. Many of which are new and now accessible to retail investors. Prior, high borrowing fees and barriers to entry made it only feasible for funds with with a significant AUM and open mandate. Now we have:

• Inverse leveraged ETF’s offering a low opportunity cost way of managing drawdowns and protecting investors with long positions during periods of large and lasting declines.
• It can give retail investors a chance to make gains during a bear market. Rather than leaving only short sellers to profit, it can help contribute to the rebound and to the long term accumulation of wealth by new and small investors. These gains will likely be redistributed to those who need them the most or reallocated to sectors more deserving of capital based on the FREE MARKET.
• Options, primarily buying puts allows for a set amount to be allocated to stocks or securities that could drop, but have a high chance of appreciating in value enough to offset the limited loss caused by the put expiring useless. Without any way of preventing rapid price declines from causing shareholders to sell more, and more, the innovation, new companies and higher risk plays would become impossible as the cost of margin (or clients with new money) required to stick it out prevents a buy and hold alternative.

For example, since I purchased Canadian and U.S. energy stocks during their lowest points: I have been able to hold those positions as they appreciate in value by almost 100% or more because I know that I can buy puts without costing much money as they expire and I repurchase OTM contracts at regular intervals to save my portfolio from a Blackswan event like 08 or increase my returns when an event like Covid-19. I may not have the 20X gains some investors have earned this year, but at least I know how much my loss could amount to if a meltdown occurs.

• The F strategy is easy to follow and would have prevented situations like GME and many other times where funds blow up overnight. Forget shorting any of the:

1. Frauds: If you are taking on a short position because you think a company is being fraudulent, you risk being right but still taking a big L because the company did something fraudulent, illegal or questionable to cover up the same reason to short in the first place. “Fake it till you make it” has been used by companies backed into a corner and forced to produce results or go under. We have seen banks and fortune 500 companies committing fraud or crimes because the penalties are negligible and the rewards are great.
2. Failures: Shorting a failing company can and many times IS asking for trouble because changes in events, new information, technological breakthroughs and cheap debt can give the failing company a chance to pivot and very quickly reverse a trend even after it appears impossible. For example: AR is an energy company in the US that had to deal with low commodity prices, an oversupply of domestic and international crude as well as high borrowing costs. It had a 25+% short interest as it hovered around bankruptcy and dropped below a dollar per share during the worst of the pandemic. Rising oil prices then gas prices, and very low borrowing costs allowed for the struggling company to refinance, cut costs, face less competition and pay down high cost debt. No longer a failing company, many believed despite its massive free cashflow and huge reserves it will drop following a short lived rally thanks to a regime change and aggressive climate policies. Wrong. They shorted it up to $7, with 16% of the float still accumulating losses as of Jan 15.
3. Fads: My last F is particularly interesting right now because of the record levels of short interest in stocks like TSLA and AMC. During a period of intense buying and high rates of participation from the overall marketplace, the potential for price action driven by sentiment alone has never been higher. The time horizon and risk appetite for the AVERAGE investor (very different from a few years ago) combined with access to information faster, cheaper and easily manipulated information can lead to irrational (or rational depending on how you view it) price appreciation in companies that should otherwise have no reason to be rising. Disruptive technology, the FOMOGROMO effect (how I describe the fear of missing out on rapid growth perpetuated by rapid growth) and central banks changing their behaviors. The old saying “The markets can stay irrational longer than you can stay solvent is so relevant.” Fads can also become the norm, and by assuming the vacuum created by the disappearance of a trend/fad will cause your short position to pay of and produce a quick gain: you will be surprised to see the emergence of structural changes cementing the fad into long-term patterns of behavior initially thought to be impossible or very unlikely. For example, at the height of the pandemic, equities such as the IEF (a fixed income 10-year bond etf) rose to record highs as the flight to safety and market turmoil caused a massive demand for low risk, highly liquid fixed income ETFs. Further supported by the Fed buying assets like they are going out of style in fear of a deep recession following the lockdown. After the vaccine showed effectiveness and the economy began returning back to normal, I purchased a very small number of puts that would pay out substantially if nothing happened and more if the economy showed a strong recovery. This should be especially true with rising inflationary pressure. It was not a FAD, the Fed is apparently going to keep buying these assets until the M2 supply hits GME/TSLA levels. (Both two of the most shorted stocks return the highest gains this year.)